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Tax and Financial News for March 2015

Lesser Known Trusts Can Create Big Tax Savings

The big issue for tax planning with trusts is who gets the tax liability. Different trusts attach the tax liability to different sources. This is important because it determines how the trust impacts income taxes versus estate and gift taxes.

There are two types of lesser known trusts – Intentionally Defective Grantor trusts (IDG) and Incomplete Gift Non-Grantor trusts (ING). Each attaches the tax liability associated with the assets and the income they produce to different sources.

IDG trusts are often used by well-off families to reduce the gift and/or estate tax paid during a shift of assets from generation to generation. This type of trust allows the parents make a gift to their children while they are still deemed the owners for the purpose of income taxes. Transferring a gift in the present instead of at the time of death creates a situation where the value that the gift tax is imposed on in the present will be significantly lower than the estate tax that would later be imposed at death (assuming the asset appreciated in value). Sometimes known as an estate freeze, this maneuver can provide large tax reductions; however, they also produce another benefit.

IDG trusts are called “intentionally defective” for a reason. This type of trust purposefully makes a defect to stop the completion of the gift for income tax purposes. In situations where the family overall will owe income tax on trust assets, it allows the parents to pay the income taxes now and reduce the ultimate size of their estate. This can be helpful since assets transferred via the estate are often taxed at a higher rate than the decedent’s income rate.

A related trust is the Incomplete Gift Non-Grantor trust. An ING tries to accomplish the opposite of an IDG. ING trusts create a transfer that is completed for income tax but not for estate tax purposes. In this case, the parents are the beneficiaries of the trust.

Take the situation where the parents have assets and they want to keep ownership. Also, assume the parents have significant income from investments or plan to incur a gain from the sale of a business. In situations like this, an ING trust can become a valuable planning device.

With an ING trust, the parents no longer own the assets for purposes of income taxes and the trust becomes its own taxpayer. Additionally, since the trust acts as a separate taxpayer, it can have its own domicile that can be set up in a state lacking any tax on income. As an example, assume the state you live in has an 8 percent income tax rate and you have $80,000 of interest income. If you transfer the interest income producing asset into this type of trust domiciled in a state without income tax, you would save $6,400 per year.

Does this sound too good to be true? Consider that the Internal Revenue Service first recognized the ING trust structure in 2001 via a private letter ruling. Since then, there has been substantial case law in the U.S. tax and appellate courts affirming this trust structure.

The remarks above are intended as general commentary and are not intended to replace specific advice and counsel from tax and investment professionals.

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